Australia's first truly domestic inflation cycle in decades

Australia may be facing its first truly domestic inflation cycle in decades. Productivity stagnation, rising labour costs and entrenched services inflation have boxed the RBA into a narrow corridor. Inflation will ease only when structural constraints - not just interest rates - are addressed.

Introduction

The latest inflation figures landed with an uncomfortable sense of deja vu. After two years of steady but fragile progress, Australia finds itself stuck again: headline inflation has jumped - partly a numerical artefact of state energy subsidies rolling off - and core inflation has edged higher as well. The easy phase of post-pandemic disinflation has now largely run its course. What remains is a more stubborn, homegrown cycle, driven by wages outpacing productivity, persistent services inflation, and a domestic cost structure that has proved unexpectedly rigid.

For the first time in decades, Australia may be facing a truly domestic inflation cycle. Global shocks still influence the edges of the data, but they no longer explain the core behaviour of prices. This shift matters: when inflation is domestically driven, it fades more slowly, responds more directly to local cost structures, and narrows the RBA's corridor for manoeuvre.

To understand why inflation is proving sticky - and why monetary policy is now so constrained - we need first to clarify the basic mechanics of inflation and the kind of cycle Australia is experiencing.

Understanding Inflation: Concepts and Context

Key Definitions

Inflation is the broad, sustained rise in the general level of prices across the economy. Individual price changes do not by themselves constitute inflation; inflation refers to the collective movement. Persistent or sustained inflation is the kind that worries central banks and policymakers - pressure that persists after temporary shocks fade.

Disinflation occurs when the rate of inflation slows, even though overall prices are still rising. Deflation refers to a general fall in prices, usually associated with recessions and rising real debt burdens. Stagflation is the combination of high inflation and weak or negative growth - the most difficult environment for policy, because tools that fix one problem typically worsen the other.

The RBA targets 2-3 per cent inflation, "on average, over time," with 2.5 per cent serving as the informal anchor. Economists prefer a low positive rate to zero inflation because it absorbs shocks, preserves room for interest-rate cuts, and allows real wages to adjust in a world where nominal price cuts are rare.

With these concepts in place, the shape of Australia's present inflation becomes easier to read.

Australia's Current Inflation Profile

Australia is now past the "easy" disinflation phase driven by the normalisation of global supply chains. Goods prices, which fell through 2023 and early 2024, have firmed again. A softer Australian dollar is importing additional inflation through fuel and tradables.

Yet the central driver is domestic. Services inflation remains elevated and stubborn, shaped by rising unit labour costs, higher rents, insurance premiums, and regulated services whose supply adjusts slowly. This form of inflation reflects the economy's own cost structure and does not fade automatically.

Understanding how Australia arrived at this point requires tracing the evolution of inflation through the past four years. The drivers have changed markedly-and those shifts explain why the remaining inflation is proving so persistent.

Demand, Supply and Cost Structure

Inflation emerges from the interplay of demand, supply, and costs. Since 2021, Australia has moved quickly through distinct phases.

The first was driven by global supply shocks - COVID-era factory shutdowns, shipping bottlenecks, labour shortages, semiconductor scarcity, and the surge in energy and food-commodity prices after Russia's invasion of Ukraine. The following charts are illustrative of global commodity price shocks in 2022.

The second phase was demand-heavy: forced savings accumulated during the lockdowns, government payments lifted household balance sheets, and the reopening unleashed a burst of consumption into a supply-constrained economy. Inflation spiked. That impulse faded through 2023-24 as savings buffers thinned and the RBA's earlier tightening cooled discretionary demand.

What remained by late 2024 was cost-structure inflation: price pressures "baked into the system" rather than driven by temporary shocks or spending surges. It is slower moving and domestically rooted, anchored in wages, rents, insurance, and regulated services. As headline inflation stepped down and labour-market conditions softened, the real stance of policy tightened, making the existing cash rate increasingly restrictive. This created the conditions for the RBA to begin easing in early 2025, even though the remaining inflation pressure was still primarily domestic.

By Q3 2025, a clear wedge opened between goods inflation and tradables inflation on a year-ended basis. This is unusual: global prices typically anchor goods prices. The goods-tradables gap shows that inflation is not simply "services-driven"; domestic cost structures are now running through the entire supply chain, lifting the price of goods even where global disinflation should be doing more work.

A further structural factor is the rapid expansion of government consumption, which has risen to a record 22.6 per cent of GDP, driven substantially by the NDIS, aged care and health services. These sectors are labour-intensive, face chronic productivity constraints, and adjust slowly on the supply side. As government has expanded its funding and provision of these services, strong demand growth in care and health has run ahead of supply, intensifying competition for workers and contributing to broader wage and cost pressures across the services economy.

But rising costs alone do not explain why inflation has persisted even as global pressures eased. For that, we must examine the economy's central constraint: productivity.

Why Productivity Has Stalled

Productivity sits at the centre of Australia's inflation problem. The long-run trend has deteriorated steadily over two decades: the 10-year growth rate in GDP per hour worked has fallen from around 2-2.5 per cent in the early 2000s to near zero today. This is not a cyclical dip but a structural slide, visible across industries and persistent through multiple policy regimes. When the underlying engine of efficiency weakens, the economy's capacity to grow without generating inflation shrinks with it.

The level data tell the same story in a different form. In practical terms, the economy is producing little more per hour worked than it did before COVID, even as labour and capital costs have climbed.

The source of the slowdown is broad-based. Decomposition shows weak capital deepening-firms have not invested enough in new machinery, digital tools or physical infrastructure-and patchy multifactor productivity, reflecting constraints across regulation, planning, energy, logistics, and competition. The shift toward labour-intensive services has contributed, but it cannot explain the scale of the shortfall. What is missing is the combination that drives sustainable productivity growth: new capital, new technology, new processes and fewer bottlenecks.

The rapid shift to hybrid work may have contributed modestly to frictions in coordination, information transfers and skills development - though measuring this effect is difficult and the evidence remains contested.

The productivity stagnation has direct macroeconomic consequences. When productivity stalls, wage growth becomes inflationary rather than living-standard enhancing: each dollar of additional pay translates into higher unit labour costs rather than higher real output. Services inflation becomes more persistent, the NAIRU edges higher, and the economy's non-inflationary speed limit falls. Monetary policy must then work harder for smaller gains, tightening the RBA's corridor to a degree Australia has not experienced for decades. Weak productivity is not just an economic disappointment - it is the structural constraint shaping the entire inflation cycle.

Capacity and the Output Gap

Potential output - the economy's speed limit-has shifted. Migration collapsed and then surged. Workforce participation changed. Capital deepening slowed. Supply chains were rewired. Infrastructure constraints tightened.

If potential output is lower than assumed, the economy may have been running hotter than the headline numbers suggested. That helps explain why inflation has remained sticky even as GDP growth softened and unemployment rose.

Expectations further complicate the picture.

Inflation expectations are behaving differently from the 2010s. Long-run expectations remain anchored, but short-run expectations have drifted and become more backward-looking, with workers and firms referencing the recent inflation experience rather than the RBA's target. In a services-heavy, capacity-strained economy, this backward-looking dynamic becomes more inflationary: wages respond to realised inflation while output cannot adjust quickly because productivity is weak. Firms, facing higher unit labour costs, have passed these pressures through more readily than they did during the low-inflation decade.

These shifts in expectations matter not just for firms and unions but for households, whose purchasing power has moved in complex ways throughout this cycle.

Real Wages and Living Standards

Real wages fell from 2022 to 2024, squeezing household purchasing power. Nominal wages have since grown faster than inflation, stabilising real incomes, but the improvement is limited. Because productivity has not increased, higher nominal wages translate into higher unit labour costs rather than higher real living standards.

If households are being squeezed, it is tempting to imagine that firms must be gaining. The data tells a more nuanced story.

Corporate Margins and Pricing Power

Profit margins surged in a handful of industries during the acute supply-shock phase of 2021-22, the aggregate picture is far more subdued. However, the national profit share has already retraced most of its pandemic-era rise and is now close to its long-run average. That means the recent persistence of inflation cannot be pinned on margin expansion or "greedflation". Firms are not taking an unusually large slice of national income; if anything, their share has been edging down as cost pressures have intensified. The data makes clear that margins are not the dominant force holding inflation up.

By contrast, unit labour costs have risen sharply and remain elevated. Nominal wages have accelerated while productivity has stalled, meaning each unit of output now requires more labour cost to produce. ULC growth reached its highest rate in decades during 2022-23 and, while easing gradually, remains well above what is compatible with the RBA's 2-3 per cent inflation target. This dynamic - wages growing faster than output per hour - is the core of Australia's domestic inflation problem. When productivity is flat, even moderate wage growth becomes inflationary, and firms pass these higher costs through to prices across the economy.

Another factor often overlooked is migration, which interacts with both demand and supply-on different timelines.

Migration's Dual Role

Migration is inflationary in the short run and disinflationary in the long run. In the short run, population growth boosts demand for housing and services faster than supply can adjust; rents rise, vacancies fall, and infrastructure strains. In the long run, migration expands labour supply and productive capacity.

Australia's population dynamics swung sharply through the pandemic and its aftermath. Population growth collapsed in 2020-21 as border closures pushed net overseas migration close to zero, before rebounding at unprecedented speed once restrictions eased. By 2023, annual population growth surged above 600,000 people-far exceeding pre-COVID norms-and began to moderate through 2024. It appears to have stabilised in 2025. The surge and the sustained higher rate in 2025 lifted demand for housing, transport and local services much faster than supply could adjust, tightening rental markets, straining infrastructure, and amplifying domestically driven inflation pressure. 

The timing mismatch in migration's effect reinforces the domestic character of today's inflation.

The Changing Macro Relationships

The Phillips Curve: A Moving Target

The Phillips Curve has not disappeared - it has changed shape again. Through the 2010s the curve was very flat: unemployment remained anchored around 5-6% even as trimmed-mean inflation drifted steadily lower - from around 2.5% in the early 2010s to below 2% by decade's end. Labour-market conditions had only a muted influence on price pressures.

Since 2021 the relationship has steepened noticeably, with inflation now more responsive to domestic labour-market tightness than in the post-GFC decade (though still less responsive than in the pre-GFC years). The recent curve sits around half a percentage point lower in unemployment space than during the preceding decade, suggesting - if sustained - that target inflation may now be consistent with  an unemployment rate in the mid 4s rather than the mid 5s that characterised the 2010s and earlier. The open question is whether this relationship will persist, or whether the Phillips Curve will shift as pandemic distortions fade.

Structural cost pressures - weak productivity, elevated unit labour costs, rising rents and insurance, and supply-constrained services - could push the effective NAIRU (the unemployment rate where inflation is stable) higher over time, but the current data do not provide a clear signal. The most recent observations remain broadly consistent with the existing curve and are insufficient on their own to infer a new regime.

Nonetheless, Phillips Curve dynamics do not evolve smoothly; they tend to reconfigure around crisis points. The post-GFC flattening lasted more than a decade, and the post-pandemic steepening emerged abruptly as supply chains normalised and labour markets tightened. Whether the curve has shifted position as well as shape will only become clear over time, because these structural relationships reveal themselves slowly and often only after the dust from major shocks has settled.

These domestic dynamics are mirrored, though imperfectly, in other advanced economies.

International Context

Inflation did not break out in Australia alone after COVID. Almost every advanced economy experienced a near-simultaneous surge in prices as the pandemic unwound. The next chart shows the global pattern clearly: inflation rose and fell together across the OECD, with Australia tracking close to both the monitored mean and median. This synchronisation reflects how deeply interconnected global supply chains, commodity markets and financial conditions have become.

Relative performance also tells a story. Australia's initial inflation spike was broadly mid-pack-less severe than the US or UK, but steeper than Japan or Germany. The difference emerged in the disinflation phase: other economies have fallen back toward target more decisively, while Australia has settled into a higher, stickier band. That divergence is not because global forces have vanished, but because what remains is increasingly shaped by Australia's own domestic cost structures.

In a world where inflation remains elevated and uneven across major economies, domestic price setting does not occur in isolation. As other central banks struggle to return inflation to target, global pressures-via the exchange rate, imported prices, commodity markets and capital flows-will make the same job harder for Australia.

But there is one further layer shaping the persistence of inflation in Australia: the long tail of the easy-money era.

The Monetary Overhang

Australia experienced a sharp, policy-driven expansion in the money base during the pandemic as the RBA implemented quantitative easing (QE), yield-curve control, and term funding programs. The monetary base has since fallen sharply as quantitative tightening (QT) proceeds - from a peak above $550 billion to around $308 billion - but remains well above its pre-COVID level.

More significantly, broad money (M3) has shown no reversal at all. Despite QT, M3 has continued to rise steadily, now sitting more than 30% above its pre-COVID trajectory. The monetary expansion of 2020-22 diffused through bank balance sheets and remains embedded in deposits and credit aggregates, sustained by ongoing private credit creation.

The surge in liquidity created during the pandemic has been unwinding only slowly. QE expanded the money base, QT has reduced it, but broad money has continued to rise because the liquidity injected into bank balance sheets supported deposits and credit. This matters less for inflation itself - money growth is not automatically linked to price growth - than for the transmission of monetary policy: a thicker cushion of deposits, stronger balance sheets and easier bank funding all blunt the effect of higher rates. In a capacity-constrained economy, that friction slows how quickly demand cools and narrows the corridor in which the RBA can operate.

Navigating the Narrow Corridor of Monetary Policy

Why the Corridor Is Tight

The RBA began cutting rates early in 2025 as unemployment rose and consumption softened. But those cuts weakened the Australian dollar, importing inflation through fuel and tradables. With inflation not convincingly falling, the Bank has paused. The risks on both sides have grown: cut too soon and risk entrenching inflation; hold too long and risk unnecessary labour-market damage.

Understanding how the RBA interprets these pressures requires a framework, and the Taylor Rule offers a useful way of seeing why this episode differs from earlier cycles.

The Taylor Rule: Why 2025 Is Different From 2022

A helpful way to understand this shift is through the Taylor Rule - a simple framework linking the appropriate policy rate to how far inflation and output have strayed from target. The RBA does not follow the rule mechanically, but it pays attention to what it implies.

In 2022, the Taylor Rule pointed to much higher rates than the RBA delivered. But inflation was largely supply-driven - insensitive to interest rates - and the priority was to prevent expectations from unanchoring. The Bank tightened enough to signal resolve without derailing recovery.

In 2025, inflation is domestic, services-heavy and demand-reinforced. Monetary policy is more potent, and the Taylor Rule bites harder. If inflation fails to fall, the RBA may have to follow the rule's implied path more closely. In 2022 the task was stabilising expectations; in 2025 it may be stabilising inflation itself.

Monetary policy does not operate alone, however. Fiscal settings shape the landscape in which the RBA must act.

Fiscal Policy's Role

The Commonwealth has returned to modest deficits after two years of surpluses, though fiscal settings remain broadly neutral for aggregate demand. But the design of cost-of-living measures-especially energy rebates-has made inflation noisy. These rebates pushed CPI down when active and lifted it when they expired, complicating the RBA's real-time reading of inflation momentum.

The Structural Constraint: Productivity

The Foundation of Everything Else

Weak productivity underlies almost every aspect of the current inflation cycle. When productivity stalls, wage growth becomes inflationary, services inflation becomes entrenched, the NAIRU rises, the non-inflationary speed limit falls, and monetary policy must do more for less. Living standards stagnate.

Recognising productivity as the central constraint is one thing; acting on it is another.

What Would Actually Fix This

Reform agendas are long, but three priorities matter most.

• First, accelerating housing and land-use reform to ease structural bottlenecks in construction and rents.
• Second, modernising the electricity grid and expediting the energy transition to stabilise a volatile and costly input.
• Third, lifting non-mining investment in productivity-enhancing capital and technology to restore output per worker and revive non-inflationary growth.

Without these shifts, inflation will remain harder to control than it should be.

Conclusion

Australia is experiencing its first truly domestic inflation cycle in decades. The global shocks of 2021-22 have faded, but domestic cost structures-weak productivity, rising unit labour costs, slow-adjusting services, elevated rents and mildly unanchored short-run expectations-continue to hold inflation above target.

This is not a crisis. But neither is it a return to normality. It is a structural transition that monetary policy alone cannot manage. Inflation will eventually fall, but the journey will be slow and uneven. The RBA must steer through a narrow corridor, but the deeper task-restoring the foundations of low, stable inflation-rests with structural reforms Australia has postponed for too long.

If Australia wants inflation to settle again, it must fix the economy that now generates it.